Behavioral finance and agent-based artificial markets

Lovric, Milan (2011) Behavioral finance and agent-based artificial markets. Erasmus University Rotterdam, Erasmus Research Institute of Management, Doctoral Thesis, 228pp.

Record type: Thesis (Doctoral)

Abstract

Studying the behavior of market participants is important due to its potential impact on asset prices and the dynamics of financial markets. The idea of individual investors who are prone to biases in judgment and who use various heuristics, which might lead to anomalies on the market level, has been explored within the field of behavioral finance. In this dissertation, we analyze market-wise implications of investor behavior and their irrationalities by means of agent-based simulations of financial markets. The usefulness of agent-based artificial markets for studying the behavioral finance topics stems from their ability to relate the micro-level behavior of individual market participants (represented as agents) and the macro-level behavior of the market (artificial time-series). This micro-macro mapping of agent-based methodology is particularly useful for behavioral finance, because that link is often broken when using other methodological approaches. In this thesis, we study various biases commented in the behavioral finance literature and propose novel models for some of the behavioral phenomena. We provide mathematical definitions and computational implementations for overconfidence (miscalibration and better-than-average effect), investor sentiment (optimism and pessimism), biased self-attribution, loss aversion, and recency and primacy effects. The levels of these behavioral biases are related to the features of the market dynamics, such as the bubbles and crashes, and the excess volatility of the market price. The impact of behavioral biases on investor performance is also studied.

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